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Annual Reports

Why are the stock markets recovering?

2020-05-14 at 10:03Timo Löyttyniemi

Many people may have been puzzled by the sharp recovery of stock market during the past weeks. Since the lows of March, equity prices have risen by 30 per cent. To summarise, one could say that it’s too good to be true. Listed here are six reasons for this spectacular recovery. One of the explanations, ranked here as number 6, may be surprising.

1. Sharp fall and its recoil

A robust recovery may be explained by the nosedive that preceded it. When prices fall, nobody can tell how big a decrease would be enough. If the markets have over-reacted, even a partial recovery may be powerful. The markets are constantly looking for the right price level.

2. Stock markets and the economy are out of synch

Typically, the stock markets do not follow the same pace as the economy as a whole. In the short term, a change in interest rates is enough to explain the market trends. In the long term, stock prices are determined by the financial performance of companies. Now that the interest rates are low, it is understandable that equity prices would increase. As it is, the economic indicators continue to fall, but if they improve 12 months from now, it may provide a basis for another upswing.

The rise of the equity market suggests a quick economic recovery. However, the economy will not recover quickly from unemployment figures approaching 15–20 per cent. According to the baseline scenario, a covid-19 vaccine won’t be available until 2021.

3. Equity markets consist of companies

The GDP is not the same thing as the equity markets. They consist of the most valuable, select stocks which are additionally weighted according to size. The so-called FAAMG companies (Facebook, Amazon, Apple, Microsoft and Google) have been doing fine. Their stock prices have increased since the end of 2019. Ordinary companies are not doing equally well. The Wall Street Journal (May 8th) recognised this as one of the key factors contributing to the recovery of the market.

In the same vein, we could say Finnish businesses could do well even if the Finnish economy were to perform poorly. Finnish companies can do better if they are operating in the right markets and are not overly dependent on Finland.

4. Asset purchases by central banks

The lesson learnt from the previous crisis – the financial crisis – was that central banks need to take swift action using heavy artillery. It’s advisable to do more rather than too little. It’s a sound and important lesson – especially in terms of shortage of financing and the inoperability of the financial market. Central banks have heeded this piece of advice during the current crisis.

Of key importance in this respect was the FED’s decision on Monday, March 23rd, to purchase securities to the extent necessary to stabilise the financial markets. It was interpreted as a carte blanche, which triggered the recovery of the stock markets the next day. ”Don’t fight the FED” is a slogan that still holds true even today.

5. National rescue packages

While the measures taken by the central banks in March were necessary, they were not sufficient as such. The message powerful enough to calm the markets was not received until governments announced additional measures and made new promises. The life-saver in this crisis was the central government with its massive supportive actions. The United States was quick to launch a USD 2.3 trillion support package.

6. What if government debt doesn’t need to be repaid?

Recently, it’s been highly interesting to read proposals representing a wide range of economic theories and policies. One overriding theme seems to emerge: the view that governments may continue borrowing without worrying too much about indebtedness. A novel idea, yet attractive to many decision-makers.

The Modern Monetary Theory is gaining ground. It postulates that a country with a single central bank and single currency may safely continue to borrow as the central bank can purchase the bonds. This policy could be pursued until all resources have been deployed and inflation expectations start growing or inflation accelerating.

For the stock markets, increased indebtedness has often given an efficient boost. Additional debt sustains and amplifies economic activity. It makes up for the lack of consumer demand during the covid-19 crisis and patches up the gap in the economy created by demography. With the assistance of central banks, this policy may well be pursued for quite some time. Central banks are able to purchase significant amounts of government bonds.

One potential problem looming on the horizon is that government action may be required several times during 2020 and 2021. If so, the bill to be footed by the state will prove high. A time may come when it falls due.

The current situation – the sharp increase in stock prices – can best be crystallised by saying that “it’s too good to be true”. The current situation is good if the economy picks up quickly as a miracle. This is, however, not the case. The development will be W-shaped. The current situation is too good to be true if the robust recovery of the stock markets is due to unlimited government borrowing. This assumption may prove to be wrong. It simply sounds too good to say that the bill will never have to be paid.